«Secular stagnation and the euro area SUMMARY Several years after the Great Recession began, the euro area is still far from fully recovered. The ...»

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Briefing

February 2016

Secular stagnation and the euro area

SUMMARY

Several years after the Great Recession began, the euro area is still far from fully

recovered. The international economic and financial crisis has pushed down

investment levels within the EU by about 15% from their peak in 2007. Even though the

near-term prospects seem brighter, high unemployment persists in many Member

States. Some experts argue that the euro area, alongside Japan and the United States, is facing 'secular stagnation', a long-term economic stagnation characterised by a shrinking work force, low demand, excess savings and low investments, despite low interest rates and deflationary tendencies.

The complexity of the ongoing crisis and the diverging economic situations of the Member States participating in the euro area make it difficult to predict future developments, as there is no common cure for long-term stagnation. Some believe that if the demand side is spurred, it would help boost the economy. In this context, the European Commission launched a number of measures in 2015, among which the European Fund for Strategic Investments (EFSI), with the aim of mobilising at least €315 billion worth of investments in the real economy by 2017. But it is also important to improve the supply side, which shapes the investment environment.

Furthermore, in December 2015 the European Central Bank (ECB) extended its quantitative easing programme (in particular, the asset purchase programme (APP)) until at least March 2017 as a way to provide further liquidity and stability to Member States' financial markets.

In this briefing:

 Background: stagnation in the euro area  Economic assumptions in theory  Lawrence Summers' new secular stagnation hypothesis  Responses to Summers and evidence for the euro area  Outlook  Main references EPRS | European Parliamentary Research Service Authors: Gustaf Gimdal and Cemal Karakas, Graphics: Christian Dietrich Members' Research Service EN PE 573.972 Secular stagnation and the euro area EPRS Glossary Economic bubble: Such a bubble appears whenever the prices of securities or other assets rise so sharplyand at such a sustained rate that they exceed valuations justified by fundamentals, making a sudden collapse likely (at which point the bubble 'bursts').

GDP gap: The difference between what an economy is producing and what it can produce, i.e. between real and potential GDP.

Inflation rate: A general increase of prices for goods and services. The inflation rate is generally indexed year-on-year, as is the case with the harmonised index of consumer prices (HICP) used by the ECB. A low inflation rate is synonymous with price stability.

Nominal, real and equilibrium interest rate: Central banks set a short-term nominal interest rate, which then forms the basis for other interest rates charged by banks and financial institutions; this rate does not take inflation into account. The real interest rate is the nominal interest rate minus the inflation rate. The equilibrium interest rate (or natural interest rate) is the estimated real interest rate that keeps output at its potential and inflation stable under full employment, which means the economy is in equilibrium.

Zero Lower Bound (ZLB): The lowest percentage of owed principal that a central bank can set.

In monetary policy, the use of a 0% nominal interest rate means that the central bank can no longer reduce the interest rate to decrease credit costs and thereby boost investments, consumption and economic growth. As the interest rate approaches the zero bound, the effectiveness of monetary policy as a macroeconomic tool is reduced.

Background: stagnation in the euro area The euro area has not yet fully recovered from the Great Recession. The global financial crisis has resulted in a drop in the level of investment in the European Union of about 15% from its peak in 2007. Despite near-term forecasts looking brighter, many Member States are facing high unemployment. Several forecasts predict GDP growth of 1.6% (2016) to 1.9% (2017) for the euro area. However, given the downward shift in GDP forecasts by the year 2020 (see Figure 1), it will be hard to make up for the output losses incurred since the crisis began and return to the pre-crisis growth path. This will prove even more difficult as long as investments remain inadequate.

In connection with the ongoing Figure 1 – IMF 2007, 2010, 2015 forecasts for the euro area GDP stagnation in the euro area, Japan and the United States, economists have been debating whether or not they are facing secular stagnation. The debate was initiated by former US Treasury Secretary, Lawrence Summers in a speech delivered at an International Monetary Fund (IMF) conference in 2013, where he revived an idea put forward by US economist Alvin Hansen in 1938 (see Box 1).

Several experts, including Summers himself, suggest that Source: IMF. Dashed lines are own estimates, based on the three-year simple Europe and the euro area are at moving average.

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Economic assumptions in theory The relationship between demand and supply, and price and quantity, is one of the major pillars of economic theory. Demand describes the need for a good, credit or service by buyers. Supply refers to the amount the producer (or market) can offer.

According to popular market economy theories, the demand and supply mechanism will allocate resources in the most efficient way possible. 1 This mechanism (Figure 2), works in two ways: the higher the price, the lower the quantity consumers' demand,2 and the higher the price, the higher the quantity producers supply. The demand pattern can be translated into a downward sloped Figure 2 – Supply and demand curve curve; the supply relationship curve shows an upward slope. The equilibrium price (P2) would balance out the supply and demand of quantity (Q2). A price higher than the equilibrium price (P1) would increase the supply of goods and lead to a surplus of supply as the demand would decrease due to higher prices (Q1). A decrease in prices (P3) would lead to an increase in demand (Q3), and would bring about a shortage (of supplied goods).

The fundamental mechanism of demand and supply also applies to financial and capital markets, among others, as well as to the amount of a central bank's money and to investments and savings. The interest rate serves as the price for investments (demand for loans) and savings (supply of loans), it determines national income and GDP respectively (see Figure 3). At an interest rate r*, both savings and investments would Members' Research Service Page 3 of 8 Secular stagnation and the euro area EPRS be in equilibrium and financial Figure 3 – Investments and savings curve resources would be allocated in the most efficient way. In theory, changes in the interest rate would not only have an impact on the monetary base in an economy, but also on investments, consumption and savings.

Countries going through economic stagnation or recession have, in general, at least four means to cope with these challenges. Two of them – cutting or increasing public expenditure and cutting or raising taxes – are of a fiscal nature. The other two – increasing or decreasing interest rates, and direct expansion or contraction of money supply, for instance through the issue/redemption of bonds and securities – are monetary instruments. The theory of Monetarism accentuates the relevance of a steady increase in money supply for sustainable economic growth, as well as of price stability – a key element for confidence and investment. The theory of Keynesianism on the other hand lays emphasis on the demand side of the economy and its relevance for production, consumption and employment. For Keynesians, rather than austerity, countercyclical state interventions through deficit spending (such as economic stimulus packages or the increase of wages to strengthen purchasing power) are important tools for addressing recession and achieving market equilibrium.3 Lawrence Summers' new secular stagnation hypothesis Since the start of the international financial and economic crisis, many of the conventional theoretical assumptions have come into question. It seems that the supply/demand mechanism is not allocating resources in the most efficient way, and that monetary and fiscal policies aimed at countering stagnation have shortcomings.

In his 2013 speech, Summers presented his take on the puzzling situation in the United States: four years after the financial panic had subsided, the country's GDP was still falling further and further behind potential. In a paper from 2014, Summers holds that even though the economy had grown and employment had increased since the trough of the recession in 2009, the GDP gap compared to 2007 projections was still 10% (or 5% compared to the 2013 downward revision of forecast GDP). Also, only a small portion of the drop in the employment ratio had been recovered.

Another point Summers makes is that, prior to the downturn in 2007 related to the housing bubble, the economy had been growing at a satisfactory rate, with no substantial acceleration of inflation and with capacity utilisation and employment at satisfactory levels. Furthermore, the period before the stock market bubble burst in 2001 had been characterised by strong economic performance. Pointing out that the bubbles had led to full employment but not to overheating of the economy, Summers argues that this was related to the decline in the equilibrium interest rate – the rate associated with full employment of resources – and to a 'chronic problem of desired savings relative to investment'.4 Members' Research Service Page 4 of 8 Secular stagnation and the euro area EPRS This forms the basis of Summers' new secular stagnation hypothesis. In general, a market-based economy affected by secular stagnation is characterised by low or absent economic growth, low inflation and low interest rates. In such an environment, desired savings exceed desired investments, leading to declining levels of per capita income, and to declining productivity numbers.

Low inflation (for example, around Figure 4 – Secular stagnation in the loanable funds model 1% per annum) accompanied by a drop of the equilibrium rate of interest into substantially negative territory and a nominal interest rate approaching the ZLB, causes serious problems for policy-makers and central bankers. Such circumstances would make it impossible to achieve a sufficiently low real interest rate to equate savings and investments at full employment, that is, to make the real interest rate r coincide with the equilibrium rate r* (see Figure 4).

Growth would remain sluggish and the economy would continue to operate below potential (GDP2 is smaller than GDP1), 'leading to disinflation and leaving output and unemployment gap open.'5 According to Summers, there are several reasons to believe that the United States'

equilibrium interest rate has declined and that it is facing secular stagnation:

 reductions in demand for debt-financed investment, due to deleverage and greater restriction on financial intermediation;

 a declining population growth rate;

 changes in the distribution of income and an increase in inequality (in income and wealth), leading to an increase in the level of savings; and  a substantial downward shift in the relative price of capital goods.

According to Summers, as a consequence of disinflation, the pre-tax real interest rate needs to be lower now than it was before. Central banks have started accumulating reserves in which safe assets, in particular US government securities ('treasuries'), feature at a disproportionately high rate.

Summers indicates three possible options to deal with secular stagnation. The first involves remaining patient and seeing how things evolve over time. In a way this is how Japan has been tackling its decades-long sluggish growth, that some qualify as a sort of secular stagnation. The second involves reducing the real rate of interest, which is difficult to do in the context of ZLB. Moreover, it creates a risk of bubbles in connection with markets considered as 'safe havens', such as the stock market and the housing market. The third – raising the level of demand – is Summers' preferred option. This could be done by regulatory or tax reforms that boost private consumption by promoting exports or by assigning a more substantial role to public investments.

Members' Research Service Page 5 of 8 Secular stagnation and the euro area EPRS Responses to Summers' hypothesis and evidence for the euro area On his blog, former US Federal Reserve Chair, Ben Bernanke, voices his scepticism regarding secular stagnation, and maintains that the US economy is on track to full employment. Contrary to Summers, he believes that the achievement of full employment during recent decades has not required the presence of financial bubbles. 6 As for the recent slow growth in the United States, he attributes it to the slow recovery of the housing sector and the government's restrictive fiscal policies. His alternative to the secular stagnation hypothesis is what he calls the 'global savings glut', or the unprecedented hoarding of savings that occurred during the weak recovery of 2002-2006. At that time, the excessive global savings which flowed into the United States contributed to keeping longer-term interest rates persistently low. A stronger dollar led to a very large trade deficit, that is, to domestic demand being diverted to imports. Bernanke holds that this may explain why the United States' economy did not overheat. He claims that Summers is focusing on individual countries or regions.

According to Bernanke, Summers considers the frailty of capital investment to be caused by fundamental factors, for instance slow population growth, low capital needs, and a downward shift in the relative price of capital. So, while secular stagnationists advocate public investments and an expansionary fiscal policy, Bernanke's policy response would be to overturn the policies that engender the savings glut, for instance by easing international capital flows.

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